The market for ETFs has experienced lots of volatility over the past 30 years — but nothing quite like what it experienced during the market meltdown in March.
Heading into the Covid-19 crash, Canadian-listed ETFs were coming off their most successful month on record, garnering net sales of $8.4 billion in February, according to a report from Montreal-based National Bank Financial Inc. (NBF). ETF assets under management (AUM) were just north of $210 billion heading into March.
Then the wheels came off. From March 4 to 23, the S&P/TSX composite index plummeted by 33%, the Dow Jones Industrial Average shed 31%, the Nasdaq composite lost 24% and the S&P 500 was down by 29%.
ETF AUM took a beating, dropping to $191 billion at the end of March — but the flows into ETFs didn’t stop.
NBF reported that ETFs had net sales of $2.9 billion in March “despite unprecedented volatility.” Mutual funds, meanwhile, experienced net redemptions of $14.1 billion, according to the Investment Funds Institute of Canada.
Why the huge discrepancy?
Daniel Straus, vice president, ETFs and financial products research, with National Bank of Canada, says ETFs have a history of benefiting from market volatility.
Straus says ETFs still have a “comparatively small” share of the Canadian investment fund market — 11.8% in May, according to data from the Canadian ETF Association (CETFA). Investors, he notes, have far more money tied up in mutual funds.
“If there’s a giant sell-off, people sell their mutual funds,” Straus says. “And then they don’t know what to buy, so they take the default position, which increasingly is ETFs these days.”
Seeing “huge inflows” into ETFs at the incipient stages of a market sell-off — particularly into low-cost ETFs — has become common, Straus says. That’s exactly what happened in March: $4 billion flowed into equity ETFs, with $2.9 billion going into cap-weighted index funds.
“When volatility is at its peak, what you have are huge inflows into the cheapest of the cheap, and the plainest of vanilla of the index-tracking ETFs,” Straus says. “They’re extremely cheap, they’re extremely liquid and they might just be a temporary parking spot.”
Mark Raes, managing director and head of product management with Toronto-based BMO Global Asset Management, wasn’t surprised by the flows into ETFs in March.
“When you see these spikes in volatility, you actually see ETF usage go up quite a bit,” Raes says. “That really speaks to the liquidity, tradability and efficiency of ETFs and the fact that users turn to them during these periods to get in and out of markets.”
The volatility in March also tested one of the predominant myths about ETFs — that index funds have been distorting stock prices.
The argument goes like this: if investors are pumping tons of money into index funds, the stock prices of all the underlying holdings will rise, regardless of how good the individual companies are. How can there be price discovery if index funds are dictating stock prices?
“I really hope that argument has been completely dismantled by what we’re seeing happening in the market,” Straus says. “We’re still seeing big inflows into indexing, and yet stocks in the index are ping-ponging every which way based on sentiment.”
The stock prices of rental car companies and airlines plummeted in March, Straus notes, while companies like Shopify Inc. soared.
“It makes sense, theoretically, that if the entire world went passive, there wouldn’t be price-setting in the stock market,” Straus says. “This sell-off has demonstrated that we’re very far from that state.”
But the market turmoil did expose other issues. For about two weeks in March, the corporate bond market went “no bid.” As bid/ask spreads widened, corporate bond ETFs began trading at a significant discount to their net asset value. (See page 7.)
That period would have been a bad time to sell corporate bond ETFs, but also a great time to buy.
“I think initially there was a lot of concern about whether these ETFs were acting properly, and then people began to realize it wasn’t the ETFs — it was the bond market,” Raes says.
Investors who held bonds directly would have had a hard time trying to trade them during the market dislocation, but corporate bond ETFs still provided liquidity — albeit at a discount.
This ended up being a “validation point” for ETFs, Raes says: “[ETFs] were trading and their prices were moving.”
Flows into ETFs have remained positive each month since the market crash.
Gold ETFs had their best month on record in April, according to NBF, and ETF AUM crossed the $200-billion threshold once again, thanks in large part to rallying equities markets.
Net flows into ETFs were $2.4 billion in May — with fixed-income ETFs rebounding from two straight months of redemptions — then hit $4 billion in June and $6.2 billion in July.
“We were pleasantly surprised every month that we stayed positive, even as the markets took some fairly big drops,” says Pat Dunwoody, CETFA’s executive director.
ETF investors, Dunwoody says, tend to score high in financial literacy, according to research from Oakville, Ont.-based Credo Consulting Inc. That could mean they’re more likely to stay the course in volatile times.
“[ETF investors] understand what they’re investing in,” Dunwoody says. “Therefore, I think they would tend not to sell when the markets are doing crazy things. They are going to be more secure that they bought the right product long-term.”
Markets have rallied considerably since March, but Covid-19 still could deal another devastating blow, particularly if there’s a second wave of infections. If the pandemic wreaks havoc on ETF AUM once again, would fees rise as portfolio managers face declining profits?
“I don’t think market volatility and how our business evolves is going to have an impact on our fees,” says Pat Chiefalo, managing director and head of iShares Canada with Toronto-based BlackRock Asset Management Canada Ltd.
Dunwoody notes that ETFs operate on “a slim margin anyway,” and she doubts that declining revenue for ETF providers would have much of an impact on fees.
“Some of the smaller [providers] may have some concerns, because they’re not getting the asset flows that they were expecting,” Dunwoody says. “But the top 15 or 20 ETF providers — they know how much it costs to manage their products, and they’ll continue to do that.”
To date, ETF sales are far outpacing 2019 levels and are on track to set a new record.
NBF reported that flows into ETFs in the first half of 2020 totalled $22.4 billion — more than double ETFs’ net inflows during the first six months of 2019. By the end of July, ETF inflows to date were $29 billion and ETF AUM had topped $230 billion.
Steve Hawkins, president and CEO of Toronto-based Horizons ETFs Management (Canada) Inc., says that the volatility in March and April proved that ETFs don’t have the negative impact on capital markets people thought they might.
“Through all of this turmoil, Canadian investors have made ETFs the investment vehicle of choice, and we believe this trend will continue into perpetuity,” Hawkins says. “I don’t think we will ever see another year when mutual fund sales outpace ETF sales.”
Are leveraged ETFs safe for retail investors?
The day after the price of West Texas Intermediate closed at -US$37 per barrel in April, Toronto-based Horizons ETFs Management (Canada) Inc. announced it was temporarily suspending subscriptions into two leveraged crude oil ETFs.
One of the funds sought to double the daily value of a crude oil rolling futures index, while the other sought to double the inverse value of the index. In a highly volatile oil market, investors in those ETFs were at risk of losing all their money if the index moved up or down by 50% in one trading day.
“Those two ETFs have been around for 12 years, and April was the first time we saw this kind of volatility in the oil market,” says Steve Hawkins, president and CEO of Horizons.
Horizons rolled the products’ underlying exposure to a different crude oil futures contract in an effort to save the ETFs. In July, unitholders approved a proposal to permit the ETFs to use variable amounts of leverage and a new proprietary index.
But do investors in these types of products really understand what they’re buying?
Daniel Straus, vice president, ETFs and financial products research, with Montreal-based National Bank of Canada, says investors in the U.S. continued to pump “enormous assets” into futures-based ETFs during this year’s market volatility — precisely the worst time to do so.
“You may know you can transact intraday; you may know how to place an order on a stock exchange. But that doesn’t mean you have the requisite sophistication to understand how a futures-based ETF works,” Straus says.
Some industry groups in the U.S., Straus notes, have suggested futures-based and leveraged ETFs shouldn’t even be called ETFs.
“I’m sympathetic to that argument from a certain angle,” Straus says, “because ETFs are great. But some of the ETFs out there might really not be for retail investors.”
In April, the Investment Industry Regulatory Organization of Canada issued guidance stating that leveraged and inverse ETFs are typically “unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”
Although Horizons had never witnessed such a plunge in the oil market before, the company had a similar experience in the volatility futures market in 2018, which resulted in staggering losses for unitholders of two of the firms’ leveraged volatility-tracking ETFs. A proposed class action against Horizons regarding those ETFs, both of which were terminated, is pending.
Hawkins says Horizons is focused on educating investors on what they’re buying.
“These are sophisticated trading tools,” Hawkins says. “Our products specifically said ‘2X Bear’ and ‘2X Bull’ in the name. Every single piece of documentation says ‘leveraged’ in it.”
Documentation is important, Straus notes: in 2012, a U.S. district court dismissed a class-action lawsuit against ProShares Group alleging that the company had failed to adequately disclose the risks of investing in its leveraged ETFs.
“It was extremely well-disclosed that the leverage was reset daily and that those funds were not designed for any form of index-tracking targeted outcome for any period longer than one day,” Straus says.
Hawkins adds that Horizons “can’t control” who buys its leveraged products: “All we can do is try to put as much information in investors’ hands as we possibly can so that they can make an educated decision with respect to their investment dollars.”